extrinsic value

[ken.lindsay8]

hi all
just a question about extrinsic value:
1) someone says extrinsic value IS time value; i used to think this is correct until i heard the second statement as follows:
2) extrinsic value is comprised of time value and volatility value and the latter comprises the most of extrinsic value.

ok here are my questions:
1) is statement 2 correct and statement 1 incorrect?
2) if statement 2 is correct, do i NEED TO calculate out of the extrinsic value how much belongs to the "time value component" and how much belongs to the "volatility component"?
3) if the answer to my 2nd question is "yes you need to", then how can i calculate it and then use it?

Please shed some lights; any help would be much appreciated
Ken

 

[jrkob]

Here: http://www.margrabe.com/OptionPricing.html

You can run some simulations: the more in the money the option is, the smaller the theta in % of the total option price.

 

[ken.lindsay8]

Thanks for that but i'm not yet convinced.

if the options goes deep ITM it will be mimicking the stock and if it's way OTM it will be worth so little that it's almost worthless.

so my question was more focused on options whose strike prices are not too far away from ATM...

Ken

 

[jrkob]

here then...

 

[daddy'sboy]

Quote from ken.lindsay8:

hi all
just a question about extrinsic value:
1) someone says extrinsic value IS time value; i used to think this is correct until i heard the second statement as follows:
2) extrinsic value is comprised of time value and volatility value and the latter comprises the most of extrinsic value.

ok here are my questions:
1) is statement 2 correct and statement 1 incorrect?
2) if statement 2 is correct, do i NEED TO calculate out of the extrinsic value how much belongs to the "time value component" and how much belongs to the "volatility component"?
3) if the answer to my 2nd question is "yes you need to", then how can i calculate it and then use it?

Please shed some lights; any help would be much appreciated
Ken

Extrinsic value is often referred to as 'time value' - realise it's a bit of a misnomer. Extrinsic value is mostly determined by time and implied volatility and distance of underlying from the strike, but realise that other factors also impact 'extrinsic value', i.e. dividends and interest rate (both pretty inconsequential unless you're doing leaps &/or dividend paying stock). These other factors are what make up the B S model (and other pricing models).
The easiest way to understand it is by realising that whatever is not intrinsic value (which is immune to the greeks) is extrinsic value (affected by the greeks).
Whether iv or time affect extrinsic more depends on the option/underlying you're looking at. You don't need to determine how much of extrinsic is time or iv in order to trade successfully. Be aware though that if iv is high the chances are that it makes up the largest proportion of your extrinsic value, e.g. goog the day before earnings springs to mind. Or if you have a leap option that has low iv then extrinsic value is mostly made up of time to expiry.
db

 

[asap]

extrinsic is value is just time value. however, time value is clearly a byproduct of volatility. that is, when volatility increases, extrinsic also increases, because vega manufactures thetas, so to speak. so when interpreting extrinsic value, one must take in consideration its dynamic nature. in this angle, extrinsic value becomes a variable dependent on external entities, such as vega or gamma. to use a metaphor, i would say that while vega produces thetas, gamma amplifies those thetas depending on where the option position sits on the gamma curve.

so your question was how much on extrinsic value is time decay and how much is vola based. the answer is a paradox. extrinsic value is by definition just time decay. however, time decay is a byproduct of volatility and at some extend of gamma as well.

then you asked how would gauge this components weight on calculating extrinsic value. the best way of doing it is by using one of the models available on the web or a option pricing simulation toolkit. beware though that time decay by itself doesnt exist. it derives solely from volatility. that is, if vegas would eventually drop to zero, then extrinsic value would also be zero, no matter what gamma is. i guess i could end by saying that options are volatility based instruments.

 

[ken.lindsay8]

so when putting on a trade to take advantage of time decay, are we actually dealing with vega more than theta?

 

[daddy'sboy]

Quote from ken.lindsay8:

so when putting on a trade to take advantage of time decay, are we actually dealing with vega more than theta?

volatility is synthetic time and time is synthetic volatility.
db

 

[ken.lindsay8]

I know a little bit about synthetic positions but haven't heard of "synthetic Greeks"...Could you articulate?

 

[daddy'sboy]

Quote from ken.lindsay8:

I know a little bit about synthetic positions but haven't heard of "synthetic Greeks"...Could you articulate?

Mine was just a follow up to asap's comment - 'vega manufactures theta'.
I think I answered your question in my previous long winded post albeit from a slightly different perspective than asap .
Strictly speaking the greeks aren't synthetic but we use the concept of volatility behaving a bit like time and vice versa. For example an increase in implied vol for an option will have a similar effect as increasing that option's time to expiry - hence 'vega manufactures theta'.
db